FINANCIAL

ENGEINEERING
INNOVATION
SUMPRIME CRISIS
D sasibhushan-11114
The sub-prime financial crisis began with the bursting of the housing bubble in the United
States (U.S.) and triggered a global financial crisis in 2007 and 2008, which has not yet reached its end.
During several years the housing prices increased and interest rates stayed low. Sub-prime mortgages
were extensively available and refinancing was cheap. However, once housing prices started to drop and
interest rates increased, refinancing became more difficult and the risks embedded in sub-prime
mortgages could no longer be hidden. The beginning of the crisis was characterised by an unusually large
fraction of sub-prime mortgages being delinquent or in foreclosure. In addition to this, the rights of
mortgage payments and related risks were shifted from mortgage lenders to third-party investors via
securitised products, like mortgage backed securities (MBSs) and collateralised debt obligations (CDOs).
Thus, the problems in the sub-prime mortgage market extended beyond the housing market to the broader
economy. After the downgrading of several mortgage related securities the uncertainty in the markets was
intensified by the lack of transparency of financial institutions risk exposures. In August 2007 the
problems hit the financial world and caused enormous liquidity pressures within the interbank market.
Due to the widespread dispersion of credit risk and the complexity of financial instruments, the mortgage
crisis had a large impact on financial markets. Banks became reluctant to lend to each other. Share prices
and stock market indices have massively declined since July 2007. Several large banks, credit insurances
and mortgage companies have reported significant losses and have lost much of their market value. Up to
today seven small U.S. banks have failed and were taken over by U.S. regulators. Moreover, central banks
were substantially challenged by the crisis and had to take essential actions. The crisis evolved in the
market for securitized products and many problems can be traced back to securitisation and the issuance
of complex instruments. Therefore, it is necessary to gain a deeper comprehension of the products,
transactions and market participants involved in the securitisation process in order to understand the
origins of the mortgage crisis. The description of the evolution and causes of the crisis aims at giving a
deep knowledge of the factors leading to the crisis and is helping to understand the effects and
consequences on financial markets. The objective of the empirical analysis is to study the impact of the
sub-prime crisis on the return of stock, bond and commodity market indices and on volatility.

subprime lending:
The term subprime refers to the credit status of the borrower (being less than ideal), not the interest rate
on the loan itself. subprime is any loan that does not meet prime guidelines. If your mid fico score is
below 620 and you have any mortgage rates within 12 months or recent BK/foreclosure, you are
considered subprime.
Subprime lending, also called B-paper, near-prime, or second chance lending, is the practice of making
loans to borrowers who do not qualify for the best market interest rates because of their deficient credit
history. The phrase also refers to paper taken on property that cannot be sold on the primary market,
including loans on certain types of investment properties and certain types of self-employed individuals.
Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates,
poor credit history, and adverse financial situations usually associated with subprime applicants. A
subprime loan is offered at a rate higher than A-paper loans due to the increased risk.

Who opt subprime lending:
Individuals who have experienced severe financial problems are usually labeled as higher risk and
therefore have greater difficulty obtaining credit, especially for large purchases such as automobiles or
real estate. These individuals may have had job loss, previous debt or marital problems, or unexpected
medical issues, usually these events were unforeseen and cause a major setback in finances. As a result,
late payments, charge-offs, repossessions and even foreclosures may result.
Due to these previous credit problems, these individuals may also be precluded from obtaining any type
of loan for an automobile. To meet this demand, lenders have seen that a tiered pricing arrangement, one
which allows these individuals to pay a higher interest rate, may allow loans which otherwise may not
occur.
From a servicing standpoint, these loans have higher collection defaults and experience higher
repossessions and charge offs. Lenders use the higher interest rate to offset these anticipated higher costs.
Provided a consumer will enter into this arrangement with the understanding that they are higher risk, and
must make diligent efforts to pay, these loans do indeed serve those who would otherwise be undeserved.
The consumer must purchase an automobile which is well within their means, and carries a payment well
within their budget. The subprime crisis took place in the United States of America from 2007 - 2008.
Subprime was the cause of USA Economy slow down. It was the very popular news among everyone and
it became very serious issue then expected. It had caused more damage to all the industries especially
Banking, Insurance and Automobile sectors.Subprime crisis had caused big loss to the banks and now it
affected the other industries like Auto Mobile companies (GM, Ford, etc.). In the residential mortgage
business in US, the houseowner or borrowers selects a lender with the help of a broker and purchases a
house. Now these lenders or banks sell the mortgages, to intermediaries who convert the mortgages into
securities and sell them to investors, these investors purchase these securities, based on the high returns
they are going to get from the interest and principal payments received from the borrowers.
The subprime crisis, which caused the credit in the US economy to dry up had many reasons and many
important events aggravated this crisis.
How the subprime crisis started:
The subprime lending is 9% in 1996 but in 2004 it is 21%. Due to securitization, investor appetite for
mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade
ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily
transferred to others. In addition to considering higher-risk borrowers, lenders have offered increasingly
high risk loan options and incentives to them.
Homeowners had been using the increased property value experienced in the housing bubble to refinance
their homes with lower interest rates and take out second mortgages against the added value to use the
funds for consumer spending. Between 1997 and 2006, American home prices increased by 124%.Easy
credit combined with the assumption that housing prices would continue to appreciate also encouraged
many subprime borrowers to obtain ARM they could not afford after the initial incentive period. With
housing prices now depreciating moderately in many parts of the U.S., refinancing has become difficult,
leaving homeowners with higher payments than anticipated.
Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers have begun to
refer to as a meltdown. A steep rise in the rate of subprime mortgage foreclosures has caused more than
100 subprime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial
Corporation, previously the USAs second biggest subprime lender.The failure of these companies has
caused prices in the $6.5 trillion mortgage backed securities market to collapse, threatening broader
impacts on the U.S. housing market and economy as a whole.
However, the crisis has had far-reaching consequences across the world. Sub-prime debts were
repackaged by banks and trading houses into attractive-looking investment vehicles and securities that
were snapped up by banks, traders and hedge funds on the US, European and Asian markets. Thus when
the crisis hit the subprime mortgage industry, those who bought into the market suddenly found their
investments near-valueless. With market paranoia setting in, banks reined in their lending to each other
and to business, leading to rising interest rates and difficulty in maintaining credit lines. As a result,
ordinary, run-of-the-mill and healthy businesses across the world with no direct connection whatsoever to
US sub-prime suddenly started facing difficulties or even folding due to the banks unwillingness to
budge on credit lines




Causes of Sub-prime Crisis:
a) Boom and bust in the housing market
While housing prices were increasing, consumers were saving less and both borrowing and spending
more. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to
$7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal
income. During 2008, the typical USA household owned 13 credit cards, with 40% of households
carrying a balance, up from 6% in 1970.
Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428
billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period. U.S. home
mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008,
reaching $10.5 trillion. From 2001 to 2007, U.S. mortgage debt almost doubled, and the amount of
mortgage debt per household rose more than 63%, from $91,500 to $149,500, with essentially stagnant
wages.
This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes,
which caused U.S. housing prices to peak and begin declining in mid-2006. Easy credit, and a belief that
house prices would continue to appreciate, had encouraged many subprime borrowers to
obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate
for some predetermined period, followed by market interest rates for the remainder of the mortgage's
term.
Borrowers who would not be able to make the higher payments once the initial grace period ended, were
planning to refinance their mortgages after a year or two of appreciation. But refinancing became more
difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves
unable to escape higher monthly payments by refinancing began to default.
b) Homeowner speculation
Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime
mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for investment
purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these
figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes
purchased was not intended as primary residences. David Lereah, NAR's chief economist at the time,
stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006,
which caused investment sales to fall much faster than the primary market."
Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical
appreciation at roughly the rate of inflation. While homes had not traditionally been treated as
investments subject to speculation, this behavior changed during the housing boom. Media widely
reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit
without the seller ever having lived in them. Some mortgage companies identified risks inherent in this
activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple
properties.
Nicole Gelinas of the Manhattan Institute described the negative consequences of not adjusting tax and
mortgage policies to the shifting treatment of a home from conservative inflation hedge to speculative
investment. Economist Robert Shiller argued that speculative bubbles are fueled by "contagious
optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are
primarily social phenomena; until we understand and address the psychology that fuels them, they're
going to keep forming. Keynesian economist Hyman Minsky described how speculative borrowing
contributed to rising debt and an eventual collapse of asset values.

c) Mortgage fraud and Predatory lending
"The FBI defines mortgage fraud as 'the intentional misstatement, misrepresentation, or omission by an
applicant or other interest parties, relied on by a lender or underwriter to provide funding for, to purchase,
or to insure a mortgage loan.' In 2004, the Federal Bureau of Investigation warned of an "epidemic" in
mortgage fraud, an important credit risk of nonprime mortgage lending, which, they said, could lead to "a
problem that could have as much impact as the S&L crisis.
The Financial Crisis Inquiry Commission reported in January 2011 that: "...mortgage fraud...flourished in
an environment of collapsing lending standards and lax regulation. The number of suspicious activity
reports reports of possible financial crimes filed by depository banks and their affiliates related to
mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between 2005
and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and
2007 at $112 billion.
"Predatory Lending describes unfair, deceptive, or fraudulent practices of some lenders during the loan
origination process."Lenders made loans that they knew borrowers could not afford and that could cause
massive losses to investors in mortgage securities."

d) Securitization practices
The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and
retaining the credit (default) risk. Securitization is a process whereby loans or other income generating
assets are bundled to create bonds which can be sold to investors. The modern version of U.S. mortgage
securitization started in the 1980s, as Government Sponsored Enterprises (GSEs) began to pool relatively
safe conventional conforming mortgages, sell bonds to investors, and guarantee those bonds against
default on the underlying mortgages.
A riskier version of securitization also developed in which private banks pooled non-conforming
mortgages and generally did not guarantee the bonds against default of the underlying mortgages. In other
words, GSE securitization transferred only interest rate risk to investors, whereas private label
(investment bank or commercial bank) securitization transferred both interest rate risk and default risk.
With the advent of securitization, the traditional model has given way to the "originate to distribute"
model, in which banks essentially sell the mortgages and distribute credit risk to investors
through mortgage-backed securities and collateralized debt obligations (CDO). The sale of default risk to
investors created a moral hazard in which an increased focus on processing mortgage transactions was
incentivized but ensuring their credit quality was not.
In the mid-2000s, GSE securitization declined dramatically as a share of overall securitization, while
private label securitization dramatically increased. Most of the growth in private label securitization was
through high-risk subprime and Alt-A mortgages. As private securitization gained market share and the
GSEs retreated, mortgage quality declined dramatically. The worst performing mortgages were
securitized by the private banks, whereas GSE mortgages continued to perform better than the rest of the
market, including mortgages that were not securitized and were instead held in portfolio.
Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued
almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages (i.e.,
those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.

A sample of
735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime
mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.
American homeowners, consumers, and corporations owed roughly $25 trillion during 2008. American
banks retained about $8 trillion of that total directly as traditional mortgage loans. Bondholders and other
traditional lenders provided another $7 trillion. The remaining $10 trillion came from the securitization
markets. The securitization markets started to close down in the spring of 2007 and nearly shut-down in
the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of
funds. In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with
the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.
A more direct connection between securitization and the subprime crisis relates to a fundamental fault in
the way that underwriters, rating agencies and investors modeled the correlation of risks among loans in
securitization pools. Correlation modeling determining how the default risk of one loan in a pool is
statistically related to the default risk for other loans was based on a "Gaussian copula" technique
developed by statistician David X. Li. This technique, widely adopted as a means of evaluating the risk
associated with securitization transactions, used what turned out to be an overly simplistic approach to
correlation. Unfortunately, the flaws in this technique did not become apparent to market participants
until after many hundreds of billions of dollars of ABSs and CDOs backed by subprime loans had been
rated and sold. By the time investors stopped buying subprime-backed securities which halted the
ability of mortgage originators to extend subprime loans the effects of the crisis were already beginning
to emerge.
Nobel laureate Dr. A. Michael Spence wrote: "Financial innovation, intended to redistribute and reduce
risk, appears mainly to have hidden it from view. An important challenge going forward is to better
understand these dynamics as the analytical underpinning of an early warning system with respect to
financial instability."
Others argue that the instruments were understood but risk scenarios weren't properly weighted. Mortgage
risks were underestimated by every institution by failing to give considerable weight to the possibility of
falling housing prices. Probability distributions were based on past history, often using national averages.
Misplaced confidence in innovation and excessive optimism led to miscalculations by originators, banks,
GSEs, rating agencies, regulators, and academics.

GOVERNMENT POLICIES THAT HELPED IN THE SPREAD OF THE CRISIS
COMMUNITY REINVESTMENT ACT (CRA) :
The CRA called on banks to invest, lend, and service areas where they took in deposits, so long as these
activities didnt impair their own financial safety and soundness. It directed regulators to consider CRA
performance whenever a bank or thrift applied for regulatory approval for mergers, to open new branches,
or to engage in new businesses.
The CRA encouraged banks to lend borrowers to whom they may have previously denied credit.


THE ALTERNATIVE MORTGAGE TRANSACTION PARITY ACT OF 1982: also known as
AMTPA , preempts state laws that restrict banks from making any mortgage except conventional fixed
rate amortizing mortgages. AMTPA
Mortgages allowed by the act included:
Adjustable-rate mortgages, in which the interest rate becomes floating after a number of years.
Balloon payment mortgages have a large payment remaining when the loan comes due.
Interest-only mortgages only require the borrower to pay the interest on the principal balance for
the first years of the loan.

COMMODITY FUTURES MODERNIZATION ACT OF 2000 :
The Commodity Futures Modernization Act of 2000 exempted derivatives from regulation, supervision,
trading on established exchanges, and capital reserve requirements for major participants. Concerns that
counterparties to derivative deals would be unable to pay their obligations caused pervasive uncertainty
during the crisis.


SHADOW BANKING SYSTEM:
The shadow banking system is the collection of non-bank financial intermediaries that provide services
similar to traditional commercial banks. It includes entities such as hedge funds, money market funds and
structured investment vehicles (SIV). Investment banks may conduct much of their business in the
shadow banking system (SBS), but most are not SBS institutions themselves.
The core activities of investment banks are subject to regulation and monitoring by central banks and
other government institutions - but it has been common practice for investment banks to conduct many of
their transactions in ways that don't show up on their conventional balance sheet accounting and so are
not visible to regulators or unsophisticated investors. For example, prior to the financial crisis, investment
banks financed mortgages through off-balance sheet securitizations and hedged risk through off-balance
sheet credit default swaps.
The volume of transactions in the shadow banking system grew dramatically after the year 2000. Its
growth was checked by the 2008 crisis and for a short while it declined in size, both in the US and in the
rest of the world. In 2007 the Financial Stability Board estimated the size of the SBS in the U.S. to be
around $25 trillion, but by 2011 estimates indicated a decrease to $24 trillion. Globally, a study of the 11
largest national shadow banking systems found that they totaled to $50 trillion in 2007, fell to $47 trillion
in 2008 but by late 2011 had climbed to $51 trillion, just over its estimated size before the crisis. Overall,
the world wide SBS totaled to about $60 trillion as of late 2011

CREDIT RATING AGENCIES :
Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization
transactions holding subprime mortgages. Higher ratings theoretically were due to the multiple,
independent mortgages held in the mortgage-backed securities, according to the agencies. Critics claim
that conflicts of interest were involved, as rating agencies are paid by those companies selling the MBS to
investors, such as investment banks.


In a 2007 speech in London Alan Greenspan chairman of The federal reserve of the United States of
America implicitly criticized the role of ratings agencies in the crisis. He stated that the problem was that
people took that as a triple-A because ratings agencies said so.Yet when they tried to sell the products
they ran into difficulties, which shook confidence. What we saw was a 180 degree swing from euphoria
to fear and what weve learned over the generations is that fear is a very formidable challenge. As of
November 2007, credit rating agencies had downgraded over $50 billion in highly rated collateralized
debt obligations and more such downgrades were made. Since certain types of institutional investors are
allowed to only carry higher-quality assets, there was an increased risk of forced asset sales, which could
caused further devaluation. Ratings agencies such as Standard & Poors Corp., Moodys Investors Service
Inc. and Fitch Ratings have come under fire for being slow to lower their ratings on securities based on
mortgage loans to U.S. borrowers with poor credit records.


RISKS ASSOCIATED WITH SUB PRIME MORTGAGE- There are four primary categories of risks
involved with subprime mortgage which can lead to subprime crisis:
Credit Risk: This risk is borne by the lending institution and is the risk of prospective default by
the mortgage seeker. However, with the introduction of MBS, this risk is covered to an extent.
Asset Price Risk: This risk relates to the valuation of MBS, whether it will be able to overcome
the credit risk or not. However, valuation of MBS is very subjective. It is derived by calculating
the collection chances of subprime mortgage along with existence of viable market into which
these assets can be sold. Due to increasing mortgage delinquency rates, value of MBS had started
declining. On the other hand, Banks and Institutional investors had recognized substantial losses
on revaluation of their securities downwards due to Mark to Market accounting. This is due to
asset price risk.
Liquidity Risk: This risk is on account of wiping or reduction of liquidity in market on account of
above two risks. To run its operations, and generate cash, many companies rely on access to
short-term funding markets such as commercial papers and repurchase market. Companies often
obtain short-term loans by issuing commercial paper by pledging MBS. Investors provide cash in
exchange for the commercial paper, receiving money-market interest rates. However, because of
concerns regarding the value of the MBS due to subprime crisis, the ability of many companies to
issue such paper has been significantly affected leading to liquidity risk.
Counterparty Risk: This is risk on account of related parties affected by the vicious circle of sub-
prime crisis. Investment banks help companies and governments raise money by issuing and
selling securities in the capital markets (both equity and debt), as well as providing advice on
transactions such as mergers and acquisitions. Major Investment Banks and other financial
institutions have taken significant positions in credit derivative (MBS) transactions. However, due
to above mentioned risks, the financial health of investment banks has taken a southward
position, potentially increasing the risk to their counterparties and creating further uncertainty in
the market.







IMPACT ON INDIA:
The end result of the sub prime crisis is manifesting itself in myriad ways. There are direct and indirect
implications not only for the United States but for the entire world. Let us briefly the effects of this crisis
on the Indian economy.
Firstly, the subprime crisis has led to near loss of confidence in the American Stock Markets, and this has
accentuated the credit crunch. Many big investment banks have been brought down to their knees and
many others are finding it extremely difficult to stay on their feet. In order to consolidate their respective
balance sheets in the United States, these banks are unwinding positions in developing markets hence
causing down swing in these markets. A simple case in point was the intraday 1400 points fall on the BSE
in January 2008 that was brought about by Citi Bank unwinding its position in many
front line stocks in India. The subprime that was brought upon by the American financial system upon
itself is spreading its tentacles around the world. People who were not even remotely connected with the
subprime crisis are being adversely affected.
Secondly, the near recession situation in the USA has led to a loss of demand for Indian exports hence
loss of export earnings for India. The Americans are known to live beyond their means. However, on
account of the subprime crisis, all their sources of credit have dried up, and they are being forced to cut
down on their expenditures. Thus demand for imports is falling, which implies loss of revenues for
countries like India. Not only is there a loss in the goods sector, but the IT sector is also feeling the pinch.
Software development for many US firms takes place in India but as the American firms are facing an
economic slowdown, they are demanding less IT products, leading to a fall in the growth rate of the
Indian IT sector.
Thirdly, investment banks and other financial institutions are on a job slashing spree to cut costs. This
means that many jobs in India are at stake because these institutions have their BPOs in India. So the
first jobs to go will be the low end Indian BPO jobs leading to increased unemployment in India.
Fourthly, there will be serious implications for the banking sector as well. The subprime has meant that
the Indian banks have to follow stricter norms while disbursing loans to the people. These tighter norms
could prove to be counter cyclical. The argument is this people will be asked to provide collateral for the
loans given to them. Anybody who is unable to furnish the collateral will be denied a loan. This policy
will exclude a majority of the population from institutional sources of credit, thereby affecting growth
negatively.
Fifthly, there is a risk of the financial contagion spreading to the entire world. Firms like Bear Sterns,
Lehman Brothers, Meryl Lynch who once inspired confidence amongst the
investor class have now gone bust. Other giants like Citi Bank, Morgan Stanley, and AIG have been
shaken from their very foundations. Freddie Mac and Fannie Mae are under the conservatorship of the US
government. The risk is, thus, the domino effect. If one more big financial institution fails there will be a
collapse of the entire financial system of the USA.
In retrospect we can conclude that due to increased financial integration of the world, risks emanating in
one country are being transmitted to other nations. There is no doubt that the financial system of the entire
world is under great strain. The first of the dominos by the name of Lehman Brothers has fallen. The
policy makers are trying all that they can to stem the fall of any more dominos. Only time will tell
whether they succeed in their endeavour. Time is running out and the policymakers cannot afford to fail.

CONCLUSION:
Considering the lasting impact it has had on the worlds leading financial institutions, subprime, has
perhaps been the most dreaded, as well as the most oft-heard word in financial circles worldwide in the
past six months or so. Ask a stock trader and he will have plenty of tales about how the subprime demon
took a toll on him as well as hundreds of other investors, big and small.
The rumblings of a rookie investor put aside, even the more knowledgeable wizards of the global
financial power-houses have had to grapple with the after-effects of the subprime. Ironically, the
instruments that ultimately led to the crisis were produced by financial engineers hailing from the same
financial power-houses.
Therefore, this is perhaps a good time as ever, to put this in the Indian perspective, analyze the series of
events that led to this turmoil, and derive lessons that can help us avoid or at least reduce the possibility of
such circumstances in the future.